Disposition of S Corporation Stock by an Estate

Disposition of S Corporation Stock by an Estate

Article excerpt

Now that corporate income tax rates are higher than individual tax rates, and the general utilities concept has been repealed, many businesses are being structured as S corporations. However, S corporation stock requires special care when transferring it as part of an estate plan.

Planning to preserve S corporation status is usually the most important priority. When a shareholder owning S corporation stock dies, the S corporation stock is usually transferred directly to his or her estate. During the administration of the estate, the S corporation rules under IRC Sec. 1361(b)(1)(B) allow the estate to be a qualifying shareholder. Additional planning is necessary to insure that the S corporation status is continued after the stock is transferred out of the estate. To the extent that the S corporation stock is left outright to a qualifying individual such as a surviving spouse, there is no problem. However, if as part of the estate plan, the S corporation stock is distributed to a trust, the corporation will not be permitted to maintain S corporation status unless the trust qualifies as a Qualified Subchapter S Trust (QSST) under IRC Sec. 1361(d)(1). Estate planners should carefully review the client's will to establish that the ultimate recipient of the S corporation stock will be a qualifying shareholder. In addition, protection against transfers to non-qualifying shareholders should be incorporated into a shareholder's agreement.

Capital Gain Followed by Capital Loss

Another important issue that is often overlooked is the income tax ramifications of the sale of the corporation's assets, followed by the liquidation of the company. At the death of a shareholder, the tax basis of the S corporation stock is increased or decreased under IRC Sec. 1014; however, the tax bases of the assets of the S corporation are not adjusted. If the corporation sells all of its assets in one taxable year of the estate, and distributes the proceeds in liquidation in the following year, the result will be a severe income tax inequity to the estate.

The S corporation's sale of appreciated assets in the first taxable year will produce a gain that will pass through and be taxed to the estate. When the corporation is liquidated in the second year (assuming no prior distributions), the estate will have a tax basis in the stock equal to the date-of-death value, plus the gain recognized from the sale of the assets, adjusted by any other S corporation income or loss between date-of-death and liquidation. …